Walking the income-tax high wire

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By: JIM VANDER SPEK- for the North County Times January 8, 2003

How will California close its colossal budget deficit? Much of the talk hinges on raising taxes, including possible surcharge income taxes on high earners and sales taxes on services. It will not be easy, no matter which way they slice it.

Rather than worry about this now, let's take a look at steps Sacramento has already taken. Before it realized the budget mess it was in, our Legislature fully conformed our state to the federal rules for IRAs, SEPs and other retirement plans. At least for now, if you save for your retirement based on the generous federal rules, you will get the same benefit for California. Because many of the contribution limits are increasing and California rules have historically been different, this is a great development.

Now, some bad news. Teachers who have been getting a special credit for staying in their profession won't get it for 2002. Also, teachers will not be able to claim a new deduction for out-of-pocket expenses that the feds are allowing.

Another nasty surprise is that net operating losses generated in 2002 will be suspended. Up until now, if you had a bad year, you could use losses to offset income in future good years. This is especially valuable for new and cyclical businesses, and has been a dependable part of the federal tax system. California, which already never lets you carry back losses, will now make taxpayers pay full freight in a good year without considering a previous bad year.

Perhaps the change that will cause the most vocal complaints is a new withholding tax charged to sellers on real estate transactions. This is an expansion on a rule that has hit out-of-state sellers for years. By making escrow withhold and forwarding taxes to California, out-of-state sellers have been forced to report sales on a California income tax return in order to get the taxes refunded. This generated a lot of howling, but since these people don't vote in California, and might not pay taxes they owed, it made a certain amount of sense.

On the other hand, the new rules are simply a way to force Californians to lend money, interest-free, to Sacramento for a while. Since the state budget is on the cash basis, forced advance withholding payments look like real income, even if they are not.

Here is how it works: If you sell property from now on, your escrow company will withhold 3 1/3 percent of the gross selling price and send it for you to California. Escrow costs also will increase. When you file your taxes at the end of the year, you must report the sale and claim credit for the taxes withheld. There are exceptions. These include the sale of your principal residence, such as kind exchanges, sales by certain non-individual entities, and if you're a Californian prove that the sale resulted in a loss.

However, this new rule could really hurt you. For example, if you owe no taxes or if the transaction was structured to not generate cash, you still must comply. Also, those who sell on an installment sale basis face even more complicated rules.

Jim Vander Spek is a certified public accountant with offices in Escondido, contact him at Jimv@vanderspekcpas.com